On June 23, the SEC’s Office of Compliance Inspections and Examinations (OCIE) published a Risk Alert discussing three general areas of deficiencies identified by OCIE staff in recent examinations of hedge fund and private equity managers: (1) conflicts of interest, (2) fees and expenses and (3) policies and procedures relating to material non-public information. This note will focus on certain observations from OCIE with respect to conflicts of interest and the related lessons in terms of investor disclosure, which are rooted in the concept of “informed consent,” as discussed in the SEC’s June 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers (the 2019 Release).
While the Risk Alert describes deficiencies observed in examinations of registered investment advisers, the fiduciary duty and anti-fraud provisions cited by OCIE apply equally to “exempt reporting advisers.” As such, below are selected topics from the Risk Alert for private fund advisers to consider in reviewing conflicts of interest-related disclosure provided to investors.
Allocation of Investments. OCIE staff raised concerns about private fund advisers’ inadequate disclosure with respect to allocation of investment opportunities among various clients, including flagship funds, co-investment vehicles, separately managed accounts (SMAs), and employee or partner vehicles. The SEC has previously noted, in the 2019 Release, that an adviser “need not have pro rata allocation policies, or any particular method of allocation…” Further, “[a]n adviser and a client may even agree[emphasis added] that certain investment opportunities or categories of investment opportunities will not be allocated or offered to a client.” In the Risk Alert, however, OCIE staff described instances of allocations in inequitable amounts among clients “without providing adequate disclosure about the allocation process…thereby causing certain investors…not to receive their equitable allocations of such investments.”
Preferential Liquidity Terms. The Risk Alert described conflicts related to preferential liquidity rights granted to certain investors in side letters, as well as conflicts related to advisers that had set up SMAs that invest alongside flagship funds without providing sufficient disclosure to fund investors of the SMAs’ preferential liquidity terms. In OCIE’s view, such advisers’ “[f]ailure to disclose these special terms adequately meant that some investors were unaware of the potential harm that could be caused by selected investors redeeming their investments ahead of other investors, particularly in times of market dislocation where there is a greater likelihood of a financial impact.”
Seed and other Strategic Investors. In addition, OCIE highlighted seed investor arrangements and other economic relationships between advisers and certain fund investors as another area of insufficient transparency, noting that “[f]ailure to provide adequate disclosure about these arrangements meant that other investors did not have important information related to conflicts associated with their investments.”
Co-Investment Opportunities. With respect to co-investments, OCIE cited observations of private fund advisers with inadequate disclosure regarding agreements to provide preferential access to such opportunities to a subset of investors. As such, those investors may not have understood “the scale of co-investments and in what manner co-investment opportunities would be allocated among investors.” There were also failures to follow disclosed policies in allocating investments, including between flagship funds and dedicated co-investment vehicles.
 The Risk Alert cites an investment adviser’s fiduciary duty under Section 206 of the Investment Advisers Act of 1940, as amended (Advisers Act), as well as advisers’ obligations under Advisers Act Rule 206(4)-8, which is an anti-fraud provision aimed specifically at protecting pooled investment vehicles and their investors.
In two recent enforcement actions involving a hedge fund manager and a private equity sponsor, the SEC found violations of the Investments Advisers Act as a result of misleading information provided to investors in private fund marketing presentations.
In the Matter of Everest Capital LLC and Marko Dimitrijevic (April 30, 2020): Everest Capital Global Fund (the Fund), a hedge fund with AUM of $830 million at peak, was liquidated following losses sustained in January 2015 after shorting the Swiss Franc, which rose more than 30% in one day. While the SEC’s press release describes “misconduct relating to risk management,” the enforcement action is framed as a disclosure violation resulting from misleading information provided to investors in the Fund’s marketing materials.
Gross Exposure: Gross exposure numbers in Fund marketing presentations carved out currency positions without disclosing this fact. As a result, the Fund’s gross exposure was represented as ranging between 155 – 185% during the relevant period, when in fact it was over 1300%.
Concentration Limits: In addition, the marketing materials provided that the Fund “would not take concentrated positions in any single geographic region,” highlighting the lessons learned by Everest’s portfolio manager from taking concentrated bets on Russian investments in 1998. In fact, the Fund’s gross exposure to the Swiss Franc alone ranged from 400 – 900% during the relevant period.
Risk Management: The Fund’s marketing materials also described the ability of Everest’s risk team “to reduce risk independent of the investment team,” but in fact the risk team had no such authority with respect to the Fund’s currency positions. On this point, the SEC further points to the Fund’s offering memorandum, which “did not exclude currencies from the [firm’s] ‘extensive research and risk management.’”
In the Matter of Old Ironsides Energy, LLC (April 17, 2020): The Old Ironsides team formerly made energy investments for a Fortune 100 company and spun out in 2013 to become an independent energy private equity firm, with AUM of approximately $1.75 billion. The firm was fined $1 million for mischaracterizing an investment in the team’s legacy portfolio, which formed part of the track record included in marketing materials distributed to investors.
In calculating the firm’s track record included in marketing materials distributed to potential investors in Old Ironsides Energy Fund II LP (Fund II), the firm described a large, profitable legacy investment made in 2002 as a direct oil and gas investment. In fact it was an investment in another private fund managed by a third party over whose investment decisions the team had only certain voting rights, along with other investors in that fund.
By including that private fund investment as a direct investment (specifically categorized as “early stage”), the firm improved the legacy portfolio’s track record in such investments, which would be one of three investment types on which Fund II would focus. Further, the SEC highlights that Fund II’s mandate expressly excluded investments in other private funds.
With COVID-19 concerns and market volatility, advisers should consider compliance challenges that are likely to arise. This COVID-19 Checklist & Considerations for Private Fund Advisers highlights key compliance issues, questions and considerations with respect to the COVID-19 outbreak and government response. Please note that if an adviser does not document its compliance efforts, the Securities and Exchange Commission (SEC) will assume that such efforts did not occur. This checklist is not exhaustive and does not, for example, cover Commodity Futures Trading Commission considerations, which are discussed in a separate client alert.
Commissioner Peirce applauds the proposed amendments and guidance for “not bow[ing] to demands for a new [ESG-related] disclosure framework, but instead support[ing] the principles-based approach that has served us well for decades.” Citing the lack of sustainability-focused metrics disclosed in a recent sample of public disclosure filings, Peirce suggests that, “[t]here is reason to question the materiality of ESG and sustainability disclosure based on existing practices.” Further, Peirce highlights her skepticism of “calls to expand our disclosure framework to require ESG and sustainability disclosures regardless of materiality.”
Commissioner Lee, on the other hand, notes that she cannot support the proposal because the Commission has chosen to “ignore the challenge of disclosure around climate change risk rather than to begin the difficult process of confronting it.” Lee posits that investors have “overwhelmingly” made clear to the SEC, “through comment letters and petitions for rulemaking, that they need consistent, reliable, and comparable disclosures of the risks and opportunities related to sustainability measures, particularly climate risk …[and] that this information is material to their decision-making process, and a growing body of research confirms that.” In Lee’s view, the “principles-based ‘materiality’ standard has not produced sufficient disclosure to ensure that investors are getting the information they need—that is, disclosures that are consistent, reliable, and comparable.”
Chairman Clayton, in his comments, took the opportunity to summarize steps that the SEC has taken over the last several years involving climate-related disclosure, framing the SEC’s commitment as “rooted in materiality,” and citing efforts such as the Commission’s 2010 guidance on climate change disclosure, as well as continuing engagement, both formally and informally, with market participants and non-U.S. regulators. In addition, Chairman Clayton noted certain of the challenges involved, including the “complex, uncertain, multi-national/jurisdictional and dynamic” landscape as well as the forward-looking nature of much of such disclosure, which “likely involve[s] estimates and assumptions regarding, again, complex and uncertain matters that are both issuer- and industry-specific…”
Looking ahead, Chairman Clayton highlighted two “avenues of engagement that currently are of particular interest” to him:
Discussing with issuers, such as property and casualty insurers, the extent to which they use, and their experience with, environmental and climate-related models and metrics in their operations and planning, including price, risk and capital allocation decisions; and,
Discussing with asset managers that have been using environmental and climate-related models and metrics to allocate capital on an industry or issuer specific basis their experience with that process.
De Facto Materiality – A Proposal in the ESG Disclosure Simplification Act
While several ESG-related bills have been filtering through Congress, and each will likely continue to face an uphill battle, one such bill, the ESG Disclosure Simplification Act of 2019 would address the materiality question raised in the Commissioners’ public comments referenced above by deeming ESG metrics “de facto material.” As such, the draft law would task public companies with mandatory reporting, while the SEC would be responsible for defining the relevant ESG metrics based on recommendations from the permanent Sustainable Finance Advisory Committee to be established pursuant to the law.